As Risks Rise, So Do Escalation Clauses

Project developers and contractors are increasingly using escalation clauses in contracts to protect themselves from rising construction costs.

For more than two years now, a spike in the cost of building materials and a lack of supply have endangered the viability for many developmental projects and eaten into developers’ profit margins.

Also known as indexing, escalation clauses are designed to put in cost controls as builders wrestle with a very volatile market for critical items such as steel and concrete, explained real estate attorney Hal Lewis, partner at Pathman Lewis in Miami.

Mike Neal, president of Coscan Construction, which builds high-rise towers in Miami-Dade County, said he “absolutely” uses escalation clauses in deals with developers.

Neal doesn’t expect his company to see any sharp increases or lack of materials – he uses a major supplier – but then again, Neal said his company is so busy with today’s building boom that it isn’t taking any more jobs.

Overall, Neal said risk has gone up disproportionately to the fees earned by builders. The cost of concrete skyrocketed outside the control of contractors and prices jumped for a range of items, from reinforcing steel and post-tension cables to roofing materials and metal piping. Fuel prices for delivery trucks are getting passed on.

“Escalation risks have never been as high as they have been over the last two to three years,” Neal said.

Escalation clauses make sure that project owners bear the brunt of the risk, he said. Contractors can guarantee a fixed price for a project – but only for a set amount of time.

“It’s really a function of risk and rewards,” he said. “The owner is taking the risk for the whole project and profits are the reward for taking that risk.”

Neal said he’s even seeing subcontractors use escalation clauses. For many, it’s the smartest way to deal with uncontrollable issues.

Trend ‘going to get worse’

Increasing building costs is a trend that is “certainly going to get worse,” Lewis said. Many real estate insiders concur. Consider that a labor shortage already existed before hurricanes Katrina, Rita, and Wilma. And last year saw destruction from savage storms named Charley, Frances, Ivan, and Jeanne.

Pinnacle Housing Group partner Mitch Friedman said he’s seeing escalation clauses in deals with general contractors that promises a set price if the project is under way by a certain date. Otherwise, the contract gets to rework the cost of the project.

That sticks affordable housing builders like Pinnacle in a Catch-22. It takes as much as three years for a developer like Pinnacle to secure the many layers of government funding to produce subsidized rental properties.

If the cost of a project goes up significantly, affordable housing developers have to go back and ask for more funds, which can delay a project further.

As land gets more exorbitant, affordable housing developers must build more vertical structures that provide increase density. And, regardless whether if it’s an affordable or market-rate developer, the taller a building gets, the more the structure requires concrete and steel, and the more difficult it becomes to stay within budget.

Presales can hurt project viability.

A developer who has pre-sold too many units at a certain price may have to reduce the quality of a building, trim back amenities, or eat the difference if the project’s budget bloats from passed-on material expenses.

Or, a developer can return reservations and sell the units at higher prices.

“There are developers that went out and sold before they were aware that their cost would be 20 percent more,” Coscan’s Neal said.

In the past year, construction prices increased about 20 percent to 23 percent. The year prior, materials rose by about nearly 30 percent, Neal estimated.

That situation stung Cabi Developers, the Aventura subsidiary of Mexican-based GISCA, on its Everglades on the Bay project. The project became the poster child for returned reservations when Cabi had to cancel potential sales after construction costs spiked.

About 40 reservations out of 800 were returned last year for the 849-unit condominium on Biscayne Boulevard. The reservations were about $15,000 each and the units in question were marked up about 5 percent to 10 percent, depending on size and location.

So, when it came to selling his twin-tower Capital at Brickell project, Cabi CEO Jacobo Cababie opted to include an escalation clause with his buyers.

Covering an entire block, the Capital at Brickell project, at 1420 S. Miami Ave., promises 866 units off Miami’s financial corridor. According to city estimates, the project will cost $584 million to build and include 47,000 square feet for a mix of shops, dining, and services and nearly 97,000 square feet for an office condo component.

To prevent a repeat at Capital, Cabi said it would create a cushion by budgeting an extra 5 percent variance into each reservation agreement in case material prices rise.

Twenty percent deposits from domestic buyers and 30 percent from foreign buyers are required, according to Cabi. Precise pricing is still pending, but units will be marketed from $300,000 to $1 million for units from 635 to 2,200 square feet. Prices per square foot may range from $475 to $525.